Re: Response to the Bank of Canada position paper on portfolio lending

Thanks to you and your colleagues for meeting with IDA Securities Lending Committee on October 11, 2001 to discuss issues relating to the Bank of Canada proposal to lend a portion of their portfolio in the open markets. The Committee believes that the meeting was very informative and provided a useful forum to discuss topics related to the proposal.

The Securities Lending Committee supports the fundamental notion that the Bank of Canada, in times of market distress, should have the ability to make portions of their portfolio available through securities lending and/or repurchase transactions. The Committee was unanimous in the view that the central bank should have access to the markets through securities lending and/or repurchase activities to provide support at times when the market is at a standstill. The purpose of the program should be to enhance liquidity and to encourage specials market trading to increase client confidence and promote broader market participation. As you may recall from our previous meeting, a number of issues were raised that required further clarification from the Bank before the Committee could thoroughly evaluate those sections of the proposal. For those issues, listed below, the Committee will suggest a solution or make an assumption as required.

1. Alternatives to Overnight Transactions

The Bank offered to investigate the operational issues surrounding extending the term options available to the participants when the Bank decides to loan a portion of their inventory. The Committee believes that having more than one option available for Bank transactions will add density to bids and increase the flexibility of the program and therefore its attractiveness to market participants. The Committee suggests that the Bank consider overnight, 3-day, and 5-day traunches.

2. Setting the Size of Auctions

The Committee would like to reinforce the importance of knowing the total supply of an issue that is outstanding at any point in time. Market-makers use supply data to assist in setting prices. When the Bank enters the market, it will be vital to know the change in supply caused by the Bank intervention.

3. Expansion of Acceptable Collateral

The Bank informed the Committee of the possibility of expanding the list of acceptable collateral beyond the government securities listed in the Bank's original proposal. During times when the Bank would enter the market, the broadest definition for acceptable collateral that would be acceptable to the Bank would contribute to the most effective program. The Committee agreed that the list should be expanded to be consistent with LVTS acceptable collateral. The Bank will need to make known any restrictions on either the collateral asset grade or if a limit will exist on each category of collateral.

4. Margin Requirements

The Bank has two choices for administering "haircuts". The Bank could reference either the October 6, 1998 Haircuts or Margin by the Bank of Canada schedule or IDA Regulation 100 as the source for assessing margin. The Committee does not favour one source over the other.

5. Failure to Deliver

The proposal suggested an 11:00 a.m. cut-off time for delivering securities to the Bank of Canada. Members of the Committee supported the extension of the cut-off time to 4:00 p.m. in order to give market participants additional time to reacquire and deliver the securities to the Bank. In the event of a fail, the Committee suggests that the Bank "roll-over" or extend delivery to the following day. A charge should be levied based on a funding rate such as the CORRA.

The Bank asked specifically for comment on the hurdle rate to be used as the trigger for Bank involvement. The Committee considered both a repo rate that is 150 basis points below the overnight rate and a repo rate that represents 50 per cent of the overnight rate. Both suggestions could be used depending on the interest rate environment. A low interest rate environment would suggest Bank involvement once the repo rates is 50 per cent of the overnight rate and the 150 b.p. differential method would be more appropriate in a higher interest rate environment. It is the view of the Committee that the Bank should treat bonds and treasury bills differently when determining whether the market is experiencing liquidity problems. Due to the ongoing liquidity challenges in the treasury bill market, the spread should be lower before the Bank enters the market; the Committee suggests 75 b.p. Setting the hurdle lower for treasury bills is a reflection of the opportunity to lend without being too punitive. As for bonds, a repo rate of less than 50 per cent of the overnight rate could lead to intervention by the Bank.

In response to the proposal and other issues discussed at the October 11, 2001 meeting, the Committee would like to make the following recommendations to the Bank to for their consideration:

The Bank should consider removing the restrictions on size that can be transacted with individual participants. While the Treasury in the U.S. had a similar restriction, the actions taken in the wake of the September 11 events ignored this restriction in order to provide market participants with assistance at times of restricted market liquidity. Based on this recent experience, the Committee recommends removing the size restriction. If the decision is made to maintain the limit, the Bank should consider creating a limit for each issue, and a limit to the total amount that can be transacted with the Bank. The example discussed by the Committee was $100 million per issues, with a cap of $500 million.

The Committee would like to see more clarification surrounding the requirement that a net position report be completed before an institution can bid for some of the Bank's securities. Collecting data from offshore subsidiaries can be particularly difficult on short notice. Net position reporting should not be directly tied into the auction process. The Bank can reserve the right to request net position reports by the end of the business day. This will increase the accuracy of the reporting and will allow participants a reasonable amount of time to gather and compile the information.

Once the program is implemented, the Bank and members of the Committee should meet again in twelve months time to discuss the effectiveness of the program. The Bank should give future consideration to increasing limits based on evident demand with respect to any restrictions on size or collateral.

The above recommendations represent the consensus view of the IDA Securities Lending Committee. If further clarification or discussion is required on any of the suggestions, the Committee would be pleased to meet again with Bank officials or if you have specific questions related to our submission, please contact Tesse Parigoris, Chair, IDA Securities Lending Committee (416) 594-8517 or myself directly at (416) 865-3037.